How to Correct BOP Imbalances

There are three possible processes to correct BOP imbalances −

●      Adjustments of exchange rates,

●      Adjustment of nation’s internal prices along with its levels of demand, and

●      Rules-based adjustment.

Rebalancing by Changing the Exchange Rate

If a nation’s currency price is increased, it will make exports less competitive and imports cheaper.

When a country is exporting more than what it imports, the demand for its currency will increase in foreign countries because other countries ultimately seek the country’s currency to pay for the exports. Therefore, if the country is earning more, it will change (increase) the exchange rate to contain the current account surplus.

Rebalancing by Adjusting Internal Prices and Demand

A possible policy is to increase its level of internal demand (i.e. the nation’s expenditure on goods). An alternative expression for current account is that it is the excess of savings over investment. That is,

Current Account = National Savings – National Investment

When the Savings are in surplus, the nation can increase its investments. For example, in 2009, Germany amended its constitution to reduce its surplus by increasing demand.

Rules-based rebalancing mechanisms

Nations can also agree to determine the exchange rates against each other, and then try to correct the imbalances by rules-based and mutually negotiated exchange-rate changes.

The Bretton Woods system of fixed but adjustable exchange rates is an example of a rules-based system.

Keynesian Idea for Rules-based Rebalancing

John Maynard Keynes believed that surpluses impose negative effects on the global economy. He suggested that traditional balancing mechanisms should add the threat of possession of a section of excess revenue if the surplus country chooses not to spend it on additional imports.

The following graph shows the current account balances of various countries as a percentage of the World’s GDP.

World's GDP

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